The computer implemented method and system disclosed herein relates, in general, to counterparty risk management in financial markets. More particularly, the computer implemented method and system disclosed herein relates to minimizing systemic risk arising from counterparty risk of financial services firms.
Alternative asset management firms that manage hedge funds, or other firms that manage mutual funds, insurance companies or non-financial corporations herein referred to as fund counterparties, require broker dealer and banking subsidiaries of financial services firms herein referred to as derivative counterparties to provide custodial, lending, and financing services for their financial transactions through prime-brokerage arrangements, repo, stock loan, and similar financing agreements. The derivative counterparties also trade financial derivative products with derivative trading subsidiaries of other derivative counterparties. In addition, derivative counterparties have numerous transactions with one other to manage their investment portfolios. These types of transactions result in risk to counterparties involved in the transactions, and are known as counterparty risk, which is risk of financial loss to a party for a transaction that arises from the default of the counterparty involved in the transaction. In addition, if there is a significant amount of counterparty risk within the financial system, there is an increase in systemic risk. Systemic risk is the risk of contagion of losses within a financial system. In this scenario, systemic risk arises due to a cascading chain of defaults due to the inter-linkages in the financial system. For example, a default of one counterparty results in losses to another counterparty which also defaults and so on and so forth.
The relationship between derivative counterparties and fund counterparties are many to many. For example, fund counterparties may select one or more prime-brokers to custody and finance assets and one or more derivative trading entities to enter into financial derivative transactions with. Similarly, derivative counterparties have one or more prime brokerage operations and one or more derivative trading entities.
This many to many relationship presents several structural disadvantages to the parties involved in a financial transaction. Fund counterparties are exposed to the counterparty risk of the derivative counterparties they transact with. They may not be able to recover their assets or collateral pledged in the event of the bankruptcy of the derivative counterparties and their subsidiaries. The fund counterparties are reliant on financing terms specified by each of the derivative counterparties. The financial terms specified to the fund counterparties are subject to change based on financial market conditions and the fund counterparties have to manage custodial and financing agreements across multiple financial services firms to minimize the risks, resulting in substantially higher operational complexity.
On the other hand, the derivative counterparties see the financing they provide to the fund counterparties as having significant risks relative to the return on investment. The derivative counterparties enter into large sized, low return transactions with fund counterparties thus resulting in high balance sheet usage and high levels of leverage at fund counterparties. Prime brokerage businesses at derivative counterparties re-hypothecate assets custodied at their subsidiaries by the alternative asset management firms as a source of their own financing. If several fund counterparties terminate their business relationship with a particular derivative counterparty in a short time span, that derivative counterparty will face financing crunches and financial instability as the derivative counterparty has to return excess collateral in a short time span, and reduce the balance sheet. The derivative counterparties have an incomplete view of collateral liquidity to a fund, as they can only estimate the risk of the collateral they hold or view and not the collateral held at other financial services firms. This lack of transparency results in an inaccurate view of risk for the financial services firms and contributes to higher than usual systemic risk.
Consider an example of an infrastructure of a financial market comprising alternative asset management firms and financial services firms. An alternative asset manager, for example, of an alternative asset management firm, manages a family of hedge funds, for example, fund 1, fund 2, fund 3, etc. The funds use the money invested with them to buy assets or enter into derivative contracts and generate returns for the investors. Financial services firms, for example, financial services firm “A”, financial services firm “B”, financial services firm “C”, etc. and their prime brokerage entity and derivative counterparty subsidiaries have transactions with fund 1, fund 2, and fund 3 and provide funding to fund 1, fund 2, and fund 3. For example, financial services firm “A” and its prime brokerage entity and derivative counterparty subsidiaries have transactions with fund 1 and provide funding to fund 1. Financial services firm “B” and its prime brokerage has transactions with fund 2 and provides funding to fund 2. Financial services firm “C” and the United States (US) derivative counterparty subsidiaries and European derivative counterparty subsidiaries of financial services firm “C” have transactions with fund 3 and provide funding to fund 3. Financial services firms custody assets and collaterals from funds and provide leverage to them. Investors buying stock in the financial services firms, bond investors, stock investors, counterparty investors, etc. have indirect exposure to counterparty default. Asset backed funding providers in each of the entities provide collateralized lending to, for example, financial services firm “C”. Financial regulators collect information from each of the financial services firms, for example, financial services firm “A”, financial services firm “B”, and financial services firm “C”. Each of the funds, fund 1, fund 2 and fund 3, is linked to each subsidiary of each of, for example, the financial services firm A, financial services firm B, and financial services firm “C”. Regulatory information on the alternative asset manager collected by the financial regulators is aggregated from financial services firm “A”, financial services firm “B”, and financial services firm “C”. From a regulatory perspective, the current business framework has a higher level of overall systemic risk as regulators do not have an easy way to understand the financial markets and how systemic risk arises. The regulators generally have to gather this information about the many to many relationships from multiple sources and piece together their view of how systemic risk can arise. As a result, instability at a large broker dealer or derivative counterparty has significant systemic impact on the market place and is not easily discernable or preventable in the current framework. An unwind of positions at a financial services firm results in cascading funding crunches, subsequent defaults, and significant market illiquidity.
Hence, there is a long felt but unresolved need for a fiscal and user-friendly computer implemented method and system that manages counterparty risks arising from collaterals posted by both derivative counterparties and fund counterparties with regard to financial transactions they have entered into and minimizing systemic risk across the financial system.